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Why You Should Be Terrified

Protect your portfolio from these destructive forces.

The yield curve has been inverted recently, which often foreshadows a recession or even a depression.

It appears that there is a housing bubble, and teaser interest rates are finally starting to expire. Consumer spending has been driven by people cashing in on the cheap equity in their homes. Who knows what will happen if housing prices fall, reducing homeowners' equity and their ability to use that equity to buy new gadgets from, say, China?

The subprime mortgage lending industry is imploding and capital has been drying up.

Consumer debt ratios are already at all-time highs.

And then there's the dollar. We're running record budget deficits and record trade deficits -- meaning that other countries are lending us money so that we may sustain our lifestyle. If they pull the plug on us, we could face a plummeting dollar -- likely resulting in inflation, stock market troubles, and a real decline in both wealth and income. (Wow, I haven't even mentioned war, terrorism, hurricanes, oil, derivatives, secular bear markets, or Sith Lords.)

Pulling the woolThe media focus 90% of their attention on these issues because the stories are exciting. But when it comes to investing, these matters don't even account for 10% of the big picture. Ours is arguably the most resilient country on the planet. Last century, we faced World Wars I and II, the Cold War, the Great Depression, the failure of numerous banks, the impeachment of one president, the resignation of another, an oil shock, interest rates rising from 2% to 15%, several stock market crashes, and, of course, disco. We didn't just survive -- we overcame these challenges and prospered (and danced).

These macroeconomic issues are scary. But instead of being overwhelmed by the impossibly complex whole shebang, do this instead: narrow your focus to individual companies.

The market doesn't dictate your portfolio's performance; that's dictated by the performance of the stocks you own. Even in a bear market, some stocks outperform. Your job is to find those stocks and snatch them up.

Don't be fooled: There will be risks -- but don't let them keep you up at night. Instead, focus your analysis on understanding how economic events can affect the businesses in your portfolio. If you own Bristol-Myers Squibb (NYSE:BMY) or Schering-Plough (NYSE:SGP), for example, war and hurricanes will likely be less important to you than legal issues. These two companies' businesses depend on their ability to defend their patents in court and manage their liability when they make mistakes. If you're going to invest in either firm, you should focus some effort on understanding legal risks.

Manageable mistakesBeyond these macroeconomic factors lurk two potential mistakes. The bad news is that they can destroy your returns. The good news is that they're completely under your control.

1. Not knowing what you own. The biggest mistake you can make in the stock market is not understanding what you're buying or what you already own. While the market may seem irrational, over the long term, it's supremely logical. Strong companies prosper, while weaker companies die or are devoured by competitors.

So, before you invest, make sure you have rational reasons for investing. Don't invest based on tips or stories; only invest in businesses. Make sure you understand how the business makes money and why it will continue to do so in the future. If you don't understand float or a combined ratio, don't invest in Travelers (NYSE:TRV) -- even if you've heard that it's a top insurer. If you don't know what CDMA is, then you probably shouldn't invest in Motorola (NYSE:MOT) or Alltel (NYSE:AT) -- two companies that are affected by the technology in different ways.

At Motley Fool Inside Value, to get up to speed on a company, we advise that you begin by picking through its SEC filings, such as its 10-K. These documents provide an overview of what the company does and its potential risks. Then sift through articles, conference calls, websites, press releases, and even discussion boards. Finally, distill that knowledge into a summary to understand a company's business, competitive position, and risks.

2. Buying above fair value. A second mistake that should frighten your boots off is the possibility of buying stocks above their fair value. Consider the performance since 2000 for EMC and Network Appliance (NASDAQ:NTAP). These companies are undisputedly two of the most successful tech companies around. Six years ago, investors recognized correctly that networked storage products were becoming critical to enterprises and that these businesses were two of the most dominant players in the niche. Yet investors who bought then lost roughly three-quarters of their investment in a few years.

The problem? They bought these stocks at prices way above their fair value. Regardless of how successful you are at picking the "next big thing," if you consistently buy businesses well above their fair value, you'll underperform. It's simple mathematics -- if you pay $1 for something worth $0.50, you're almost certain to lose money, unless you can find a bigger idiot willing to pay even more than you.

This dynamic is reversed when you buy below fair value. If you pay $0.50 for something worth $1, you have a decent chance of later being able to sell at a profit, and less chance of losing money. That's what value investing is all about.

Knowledge is powerThe way to deal with potentially terrifying issues is to be in the know -- know the business in which you're investing, and know its fair value. Such knowledge not only reduces macroeconomic nightmares to manageable risks, but it also puts you in a profitable position when fears of such risks are overblown.

If you want to get ahead of the pack, Inside Value can help. Our analysis of undervalued stocks will give you a head start in identifying undervalued companies. A 30-day free trial will give you access to all Inside Value content: our top recommendations, our discounted cash flow calculator, five special reports, and our discussion boards. It's free with no obligation -- just click here to give it a try. Don't be scared.

This article was originally published on Jan. 3, 2006. It has been updated.

Fool contributor Richard Gibbons is a member of the Inside Value team, a father, a husband, a chess player, a juggler, and a geek. Richard has no financial position in any company discussed in this article. The Motley Fool has a disclosure policy.